As house prices fall across Australia, should we be worried for our economy?

Are you a home owner?

If you are in Sydney, Perth and Darwin, you are losing money at a rapid rate.

In Melbourne and Canberra, prices are topping out and there is a growing risk that prices will fall through the course of this year. If your dwelling is in Brisbane or Adelaide, you are experiencing only gentle price increases, whilst the only city of strength is Hobart, where house prices are up over 13 per cent in the past year.

The house price data, which are compiled by Corelogic, are flashing something of a warning light on the health of the housing market and therefore the overall economy. For the moment, the drop in house prices has not been sufficient to unsettle the economy, even though consumer spending has been moderate over the past year.

The importance of house prices on the health of the economy is shown in the broad trend where the cities that have the weakest housing markets tend to have the slowest growth in consumer spending and are the worst performance for employment and the unemployment rate. The cities with the strongest house prices have strong labour markets and more robust consumer spending.

The Trump trade wars threaten the global economy. This is not an exaggeration or headline grabbing claim, but an economic slump based on a US inspired global trade war is a distinct and growing possibility as it would dislocate global trade flows, production chains and bottom line economic growth.

Up until a few weeks ago, there was a strong enthusiasm for the economic policies of US President Donald Trump. Tax cuts and planned infrastructure spending were seen to be good for the US and world economies. US stocks and many around the rest of the world rose strongly, to a series of record highs. At the same time, bond yields (market interest rates) surged as the market priced in interest rate hikes and inflation risks from the ‘pro-growth’ policies. It was seen to be good news.

Very few, it seems, were worried about the consequences for US government debt and the budget deficit from this cash splash, especially when the US Federal Reserve was already on a well publicised path to hiking interest rates.

About a month or two ago, a few of the more enlightened and inquisitive analysts started to focus on the fact that the annual budget deficit under Trump was poised to explode above US$1 trillion with US government set to exceed 100 per cent of annual GDP.

A debt binge fuelled by tax cuts was a threat to the economy after the temporary sugar hit.

Australians should be justifiably proud of the fact that the last recession in Australia ended in the June quarter 1991, over 26 years ago. This means around half the current workforce has never had to deal with the pain and suffering – both financial and emotional – that a recession delivers.

While the economy is hardly on fire at the moment, it is pretty safe to say there is no material threat of a recession. Indeed, there are few identifiable issues that can be seen as genuine triggers for what some are suggesting is a long overdue recession.

As 2018 kicks off, business investment is rapidly recovering from the mining sector imposed slump and public sector spending is strong. These items alone will provide a foundation for the economy for the next year or two, also supported by the export sector, which should perform well following steady growth in the global economy. Despite moderate growth in household spending due to weak wages growth and high levels of household debt, it is still expanding and adding to bottom line GDP. In other words, it is not falling and offsetting the positive news in business investment and public spending.

For a recession to emerge as a material threat, household consumption has to fall, or business investment and public infrastructure spending has to reverse sharply, neither of which are currently on the radar.

Forecasting a recession is easy

Forecasting recessions is easy and many people seem to make a living out of it.

Treasurer Scott Morrison is about to do cartwheels down the corridors of Parliament House, such is the unexpected improvement in the budget position over the past year.

A surprise surge in company tax collections, a lift in goods and services tax receipts and an undershoot in planned government spending has seen the forecast for the budget deficit for the first seven months of 2017-18 come in more than $6 billion lower than was assumed when the Mid-Year Economic and Fiscal Outlook was released in December. If this trend continues through to the end of the financial year, the budget deficit could fall to around $15 billion which would be the smallest deficit in the current cycle, that is, since the last budget surplus was recorded in 2007-08 and all of the improvement will have been driven by a surge in tax receipts.

More importantly, the improved budget momentum will almost certainly parlay through to the so-called out-years of the budget which will leave to smaller deficits and larger surpluses.

While there is always plenty of debate about the economic parameters underpinning the budget forecasts over the 3 or 4 years of the forward estimates, when Morrison hands down the budget on 8 May, he is likely to announce that budget position over the four years has markedly improved.

In just over 10 weeks, on 8 May to be exact, Treasurer Scott Morrison will deliver the 2018-19 budget - almost certainly the last before the next election.

The budget is likely to offer mixed news, but encouragingly remain on target to a small budget surplus in 2020-21.

Importantly, from both an economic and political perspective, there has been some upside to government tax receipts since the mid year economic and fiscal update was published in December. This is largely the result of company tax receipts running strongly as profits and therefore tax payments have been buoyed by higher commodity prices, boosting the financial position of mining companies. Strong employment growth has kept income tax payments flowing freely to Treasury, despite soft wages growth.

If the current speculation from Canberra is correct, and it appears to be well founded, the government will use the windfall revenue gains to promise income tax cuts on top of the company tax cuts it is currently trying to get through parliament.

Tax cuts stimulate growth

While the timing and magnitude of the income tax cuts is yet to be revealed, there is little doubt that there will be something of a sugar hit to the economy if the Coalition win the election and the tax cut legislation is passed. There will plainly be more cash in the economy rather than in the government coffers at the time the tax cuts are delivered. This would support bottom line economic growth and at the margin, add to inflation. Financial markets would also be impacted, if the US is any indication.

It has been a turbulent few weeks for financial markets, including for the Aussie dollar. The AUD has been on a roller coaster, having reached a high of 81.2 US cents in late January and a low of 77.7 US cents about 10 days ago having traded at a low around 75 cents in December.

It is currently trading around 79.5 US cents, with the market divided about which direction will break over the next 12 months.

Foreign exchange markets are driven by many factors. For the Australian dollar, there are some powerful influences that have shown to determine its fortunes. One of those is the gap in interest rates between Australian and the rest of the world. When Australian interest rates are substantially above those of the rest of the world, there is often a bias from investors towards the AUD which drives it higher. When the interest rate gap compresses, the appeal of the AUD is reduced.

Which brings us to a fascinating situation at the moment, when we compare Australia and the US. With the US Federal Reserve embarking on a series of interest rate increases and the Reserve Bank of Australia squarely on hold, the interest rate gap between Australia and the US is effectively zero. This is not only for the official cash rate, but also for 10 year government bonds. This is a rare occurrence and prospective changes in the interest rate gap is one reason why the risks favour the AUD falling back towards 70 US cents over the next year or so.

According to the wonderful Corelogic house price series, Sydney house prices have grown by 0.00 per cent over the past year.

This annual result masks what are some weaker trends for the Sydney housing market including the fact that prices have fallen 3.8 per cent from the September 2017 peak. In other words, a dwelling that was $1,000,000 in September is now worth around $962,000, a drop of $38,000.

Not horrible, but hardly the sort of thing that is going to inspire joy and optimism about the future. The unemployment rate remains at 5.5 per cent which is significantly above most estimates of full employment for Australia and is exactly the same as it was in May 2017.

In other words, there has been no progress in reducing Australia’s stubbornly high unemployment rate since the budget 8 months ago even though the government likes to crow about the level of job creation in recent times. Despite this bluster and noisy rhetoric about job creation, the fact is the unemployment rate remains uncomfortably high and no one is doing anything about it.

If the latest forecasts from the RBA’s February Statement on monetary policy prove to be correct, underlying inflation will not hit the mid point of the RBA target for at least the next two years, which is as far as the current RBA forecasts extend. The RBA inflation forecasts are predicated on annual real GDP growth registering what seem at face value, decent levels around 3.25 per cent. If this figure comes to fruition, inflation will still remain low, as the RBA notes. Implicitly, GDP growth needs to be materially faster – say 3.75 per cent per annum – for inflation to accelerate to the middle of the target band.

Conversely and obviously, if there is any slight disappointment on the growth outlook – perhaps with housing being weaker than anticipated, or global conditions undershooting the current rosy outlook that results in annual GDP hovering around 2.75 per cent rather than at 3.25 per cent – the risk on those already weak inflation forecasts from the RBA will be squarely to the downside.

The December quarter CPI figure confirmed inflation was running dead. Underlying inflation is actually decelerating with an annualised increase of just 1.6 per cent in the second half of 2017, down from 2.1 per cent in the first half of the year. While there is considerable debate why this inflation undershoot has been occurring, one simple point is that economic growth in Australia has been too low for many years. Since the start of 2013, the average annual rate of real GDP growth has been a tepid 2.4 per cent. This is a stunning 0.75 per cent per annum below what was considered the long term trend, which means that a large output gap has been accumulated over the time.

The hangover of the global financial crisis is still with us

With the economy underperforming over all those years, it is little wonder that over 13.5 per cent of the labour force is ‘underutilised’ – either unemployed or underemployed.

The RBA is finally coming around to the fact that the economy is not strong and there is oodles of spare capacity that will not be mopped up for possibly several years.

The RBA were shattered, almost personally, with the low CPI result for Q4 and the jump in unemployment in December. Of vital importance, it has come to the view that the good employment data are not representative of labour force health - unemployment and underemployment are they key.

Wages growth and hence inflation will not pick up while the economy muddles along and the slack in the labour market remains.

Indeed, some basic modelling suggest inflation is more likely to fall below 1% than reach 3% in the next 2 years, even if GDP only marginally undershoots the RBA's very upbeat outlook.

House price are falling: This is good news, for sure, but careful what you wish for. The first few months of 2018 could spell some risks if house price falls accelerate and widen geographically.

Word has it that the framing of the budget, due to be handed down by Treasurer Josh Frydenberg the day after April fools day (and around 6 weeks before the election), is more problematic than usual.

Problematic because there is some mixed news on the economy that will threaten the current forecast of a return to budget surplus in 2019-20.

Housing has gone into near free-fall, both in terms of prices and new dwelling approvals. This is bad news for GDP growth. The unexpected severity of the housing slump is the key point that will see Treasury revise its forecasts for GDP growth, inflation and wages lower when the budget is handed down.

It will be impossible for Treasury to ignore the recent run of hard data, including the weakness in consumer spending and a generally downbeat tone in the recent economic news when it sets the economic parameters that will underpin its estimates of tax revenue and government spending and therefore whether the budget is in surplus or deficit.

The prospect that interest rates will be lowered within the next few months is already starting to impact on the economy.

Here’s how.

Around the middle of 2018, financial markets were expecting the RBA to hike official interest rates to 1.75 or 2 per cent over the course of the next 18 months or so. If proof was needed that investors and economists can get it wrong, markets are now pricing in official interest rates to be cut towards 1 per cent over the next 18 months.

The about face has been driven by a raft of disappointing news on the economy, most notably the fall in house prices, the free-fall in new dwelling building approvals and a slump in retail spending growth.

Business confidence has also taken a hit and job advertisements have been falling for eight straight months. Ongoing low inflation and increasing signs of a slowdown in the global economy have simply added to the case for this dramatic change in market pricing.